A key China economic indicator took a sharp turn for the worse, with the final reading for the Caixin China purchasing managers' index (PMI) for July surprising with a drop to a two-year low.

"The downturn in China's manufacturing sector intensified at the start of the third quarter. Renewed falls in both total new work and new export orders led manufacturers to cut production at the fastest rate since November 2011," the news release said.

The reading came in at 47.8, well below the 50-mark separating growth from contraction and also lower than the preliminary reading of 48.2, which also surprised markets on the downside. The data paint a darker picture than the official China PMI, released on Saturday, which avoided falling into contraction territory by coming in at 50 for July, down from June's 50.2 and below a Reuters poll forecast for 50.2.

Caixin's China PMI data tends to focus on smaller and medium-sized companies, filling a niche that isn't covered by the official data.

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Two employees tie up steel bars at a steel-making plant in Ganyu, China.

"The weakness of numbers like the PMI does suggest that [the China economy] is having a very hard time turning around," Donna Kwok, senior China economist at UBS, told CNBC. "This isn't a terrible thing though, if you put the two numbers together, today's numbers with the weekend [official PMI]. Services are holding up and at least the biggest employers, the big SOEs (state-owned enterprises) are holding up," she added.

"I wouldn't say that we're bullish on the economy by any means. But we do think the PMI is only one of many indicators," Kwok said, noting that power generation stabilized in July. She also expects infrastructure investment held up in July as well. "For the next month, we are expecting to see the economy stabilizing on the low levels."

After the data, the Australian dollar eased to as low as $0.7287, from $0.7308 prior to the data release, although it later recovered some ground. Although it initially held steady, China's Shanghai Composite index retraced some of its earlier 1.9 percent drop to trade down around 0.8 percent.

Concerns about slowing economic growth on the mainland have spurred policy makers to action. Late last month the People's Bank of China (PBOC) cut interest rates and the reserve requirement ratio (RRR) for some lenders in a bigger-than-expected easing package. That marked the PBOC's fourth round of major action since November amid concerns that the government's annual GDP target of "around 7 percent" could be at risk. China last cut both interest rates and the RRR at the same time in December 2008, at the peak of the global financial crisis.

Some analysts aren't reading too much into the surprise PMI drop.

"The weak readings partly reflect temporary disruptions to factory activity as a result of a number of tropical storms that hit China's key manufacturing hubs over the past month," Julian Evans-Pritchard, a China economist at Capital Economics, said in a note Monday.

"In addition, although the recent stock market volatility has hurt business sentiment and may have led firms to provide more downbeat responses to the latest PMI surveys, we think it will have a limited impact on real economic activity, which we think should have continued to recover last month," he added. "We remain sanguine about the near-term outlook."

China's main stock index recently plummeted 30 percent after running up more than 150 percent in about a year. In response, the government imposed a series of restrictions to stem the fall, including a ban on new initial public offerings and a measure preventing large stakeholders from selling their shares.